Origin of the Claim Test Used to Analyze Deductibility of Legal Expenses Incurred in Patent Infringement Litigation

Deductibility of legal expenses is always a tricky issue for tax purposes.  In the situation described in Private Letter Ruling 201536006 the litigation involved a potential infringement on a patent, with a key issue being whether the legal fees incurred represented a capitalizable payment in defense of title to the patent or an ordinary and necessary business expense arising from a dispute over whether there had been an infringement on the patent.

The taxpayer in this case licensed the use of the patent from an affiliate.  The taxpayer had been granted the right to use the patent to manufacture items for sale.  The taxpayer discovered another party was manufacturing and selling items the taxpayer believed infringed upon the patent.  Under the agreement the taxpayer was required to notify the affiliate about such infringement.

While the affiliate has sole control over any legal action and negotiations with regard to the patent, the taxpayer is required to pay a portion of the legal expenses and would share in any amounts recovered.

The taxpayer filed an action against the party it believed was infringing upon the patent.  In response that party filed a motion for a declaratory judgement that either their actions did not infringe upon the particular patent or the patent had not been validly issued.  The other party did not claim that the affiliate did not have title to the patent.

Generally, under Reg. §1.263(a)-4(d)(9)(i) a taxpayer must capitalize amounts paid to defend or perfect title to intangible property if the other party challenges the taxpayer’s title to the property.

As the ruling notes, clearly these expenses were incurred in the ordinary course of the taxpayer’s business and they are also clearly a necessary expense.  Therefore the expenses meet the initial hurdle provided by IRC §162(a).  But that will not be sufficient if the requirements of §263(a) require the payments to be capitalized.

The ruling discusses the key issue here, which is the application of the origin of the claim test to legal expenses.  It notes:

The primary issue is whether they are deductible under the origin of the claim test established in United States v. Gilmore, 372 U.S. 39 (1963). The test generally determines whether an amount incurred in litigation is currently deductible under § 162(a). See also Woodward v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580 (1970). In Gilmore, the Court held that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense [is] ‘business’ or ‘personal’ and hence whether it is deductible or not…”. Gilmore at 49.

Under the test, despite being ordinary and necessary, if the taxpayer’s purpose in undertaking the litigation is to defend or protect title, those expenses will be required to be capitalized under Reg. §1.263(a)-4(d)(9)(i).

For patent related litigation in particular, the ruling provides:

The federal tax treatment of costs incurred in a patent infringement suit depends on the nature of the claims. Patent infringement costs are capital if they are incurred for the defense or perfection of title to the patent. On the other hand, patent infringement costs are deductible if they are incurred to protect against infringement of the patent. If the costs are incurred for both purposes, then a direct tracing, if possible, or a reasonable allocation of costs if a direct tracing is not possible, is necessary to determine the proper treatment of the patent infringement costs for federal tax purposes.

The ruling then determines that, in this case, the origin of the claim was not the defense of title, holding:

Taxpayer incurred litigation costs pursuant to a license agreement with Affiliate to protect the patent Taxpayer licensed. The nature of the claims against the competitor infringing the patent and the counterclaims of the competitor are not those of a dispute of legal title or ownership of the patent, but of a dispute over whether the competitor infringed upon Affiliate’s patent and whether Affiliate’s patent was properly issued. These challenges do not raise the issue of whether the patent holder is the true owner of the patent. These expenses are deductible as ordinary and necessary business expenses under § 162(a) of the Code.